An Introduction To Target Date Funds

Target date mutual funds can be an alternative to bonds and CDs for investors who do not wish to actively manage their savings. This is because these funds periodically reallocate their holdings to a more conservative mix over time as the fund holder approaches the target date – usually retirement. This relatively new category of funds has become a mainstay in the professionally managed product market because of its convenience and general correlation to fiduciary standards. Investors who are looking for an investment alternative that runs on autopilot should become acquainted with these unique vehicles.

History of Target Date Funds

Target date funds first appeared in November 1993 when Barclay’s Global iShares introduced its LifePath Portfolio. Their market share was greatly expanded when the Pension Protection Act of 2006 specified that approved default investments must be offered inside all qualified retirement plans. Because the structure of target date funds met all of the fiduciary requirements that were laid out in this legislation, they became a vehicle of choice for many money managers. Automatic plan enrollment by many employers further increased the flow of money into these funds. Between 2006 and 2013, the total assets in target date funds mushroomed from just over $110 billion to nearly $600 billion.

How They Work

Target date funds are typically constructed as funds that invest in other funds covering several categories of assets, including debts, equities and even alternative investments in some cases. As mentioned previously, these funds are designed to gradually transition from a growth-oriented portfolio allocation at issuance to more conservative holdings as the target date approaches. Most target date funds are used primarily as retirement-funding vehicles, although they are also found in some 529 plans. Some target date funds are actively managed, while others passively invest in various market indices. The rate at which these funds shift their assets is known as their “glide path,” and all funds fall into one of two categories. “To” funds structure their glide rate to achieve the most conservative allocation right at the target date, while “through” funds will not reach their most conservative allocation until after the target date in order to provide a hedge against inflation.

Morningstar now ranks more than 600 target date funds, about a third of which it categorizes into gold, silver and bronze tiers. Some target date funds are only available inside certain plans, such as the Lifecycle Funds that are available exclusively to employees of the federal government in the Thrift Savings Plan (TSP). Others are offered to the general public through brokerage channels, such as those offered by T. Rowe Price.

An example of how target date funds work is shown using the Lifecycle Funds:

The Lifecycle (L) Funds in the TSP are managed by Blackrock Capital Advisors. They represent an amalgamation of the other five core funds in the TSP:

G Fund – Invests in a non-marketable government bond with guarantee of principal.

S Fund – Small cap fund. Invests in the Dow Jones Total Stock Market Return Index, which consists of the other 4500 companies in the Wilshire 5000 Index (high risk).

I Fund – International Fund. Invests in the Morgan Stanley Europe, Australasia and Far East Fund, which holds stocks in companies in 22 other developed countries outside the United States (high risk).

The L Funds can be classified as passively managed “to” funds that are designed to start paying out at the target date. Every L Fund matures at the beginning of a calendar decade. The current L Funds are the L2020, L2030, L2040 and L2050. There is also an L Income Fund for those who will need retirement income either now or before 2015. The other funds are initially allocated with a strong bias toward the three stock funds. The portfolio managers at Blackrock Capital will then reallocate a small percentage of the money in the three stock funds into the two bond funds every 90 days until the target date, at which time 80% of the fund assets are allocated to the bond funds with the remainder split among the stock funds.

Pros and Cons

The hands-off approach offered by target date funds gives investors who eschew active investment management an easy way to put their retirement or other investment-savings plans on autopilot. But the limitations that come with these funds also need to be understood in order to get the most out of them. These funds can also differ substantially in regard to their level of risk and allocation of assets, even among those with the same target date. Few to none offer any type of guarantee of principal, despite their current status as default savings vehicles for qualified retirement plans.

Shareholders need to check the allocation of their target date funds periodically to see how heavily weighted they are in equities; a fund that still has 40% of its assets in stocks five years before the target date may not be an ideal choice for conservative investors. Those who are unsure of how their fund may look when the time comes for them to make withdrawals should look at the target date funds offered by their carriers that have already reached their maturity.

The hands-off approach offered by target date funds gives investors who eschew active investment management an easy way to put their retirement or other investment savings plans on autopilot. But the limitations that come with these funds need to be understood in order to get the most out of them. These funds can also differ substantially in regard to their level of risk and allocation of assets, even among those with the same target date. Few to none offer any type of guarantee of principal, despite their current status as default savings vehicles for qualified retirement plans. If the allocations of a fund seems too risky, another alternative may be more suitable.

Some funds levy hefty sales charges and management fees, while others are sold as no-load offerings with minimal ongoing expenses. And many investors have clearly not bothered to do their homework on the funds into which they put their money. A 2012 study conducted by the SEC revealed that only a third of respondents understood that these funds will not provide guaranteed income during retirement. In addition, because they have a wide and changing product mix, people with other assets invested outside these funds need to remember to include their target fund holdings when they do asset allocation and review how their portfolios are balanced.

The Bottom Line

The amount of money pouring into target date funds shows no sign of slowing. One management consulting firm estimates that the total assets in these funds could grow to close to $4 trillion by 2020 – about half of all money invested in any kind of retirement or pension plan in the U.S. Investors who use them must do their homework to ensure the fund they choose genuinely matches their risk tolerance, investment objectives and time horizon. For more information on target date funds, consult your stockbroker or financial advisor.

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